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September 20, 2013

Finally, a modern pension system

The Pension Fund Regulatory and Development Authority Act 2013 is helpful for constructing a modern pension system for rapidly ageing India but major challenges lie ahead.

The long delayed passage of the PFRDA (Pension Fund Regulatory and Development Authority) Bill 2013 (now Act) in the Lok Sabha on September 4, 2013 is a helpful step in constructing and sustaining a modern pension system to meet the challenges of rapidly ageing India.

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The United Nations projections suggest that in 2050, only 37 years away, the two largest population cohorts in India will be respectively women and men seventy years of age and above. The number of aged (defined as those sixty years and above) will more than triple between 2010 and 2050, from 93.3 million to 296 million, while as a share of the population, the increase will be 2.4 times, from 7.7 percent in 2010 to 18.3 percent in 2050. The above suggests that the number of aged (and near-aged) for whom old age income security issues will become increasingly more significant will become staggeringly large.

The challenges of constructing and sustaining a modern pension system in India are not just financial, but would involve many other aspects of the economy (such as labour markets, public finances, delivery of public services, ability to absorb new technologies, and health care).

The international experience suggests that rapid pace and level of ageing significantly impact on social and political dynamics as well, which need to be carefully managed. In India’s case, an additional complicating factor is that by 2050, majority of Indian population will be classified as urban, increasing the need for more formal pension structures.

The expectations of the population concerning adequacy, fairness, and quality of services will also be much higher than they are today, requiring different skill-sets, and significant governance and technological innovations by provident and pension fund organisations, their trustees, regulators, and policymakers. Greater pension literacy, for which the Act makes provisions, while essential, should not just be confined to the members, but also involve other stakeholders, including the trustees.

It is in the above context of the enormity of the challenges ahead in constructing and sustaining a modern pension system that the passage of the PFRDA Act 2013 must be analysed.

The discussion of why the passage of the Act is helpful and outline of major challenges that lie ahead may be as follows.

First, it brings to a closure the initial phase of the far-sighted initiative of the NDA (National Democratic Alliance) government in December 2002, broad contours of which have been retained in the 2013 Act.

The PFRDA will now formally become a statutory authority, enabling it to focus on enhancing professionalism of all the stakeholders (including itself!) in the pension industry; while the policymakers can focus on greater policy coherence and increasing choice and contestability among pension products and providers.

Second, the 2013 Act broadly retains the main features of the pension design and architecture envisaged by the NDA in 2002. These include mandatory nature of the membership in a contributory (by both employers and employees), portable scheme, permitting power of compound interest through long term accumulation of funds, and with a combination of lump-sum and periodic income (through mandatory purchase of annuities for at least 40 percent of the accumulated balances) in retirement. NDA’s provision of permitting states to utilise the NPS architecture and PFRDA’s regulatory purview has meant that twenty-three states have joined NPS, though Maharashtra, Tamil Nadu, and Kerala are yet to join despite issuing notification.

The PFRDA data suggest that as of August 7, 2013 there were 1.2 million Union government and 1.8 million State government employees in the NPS for a total of 3.0 million mandatory members, constituting little more than one-eighth of the total government employees

The current accumulation of balances in the mandatory scheme is rather low, only about 0.3 percent of GDP. But as the number of contributors and their contribution density (number of monthly contributions divided by the total lifetime covered months) increase, these assets will increase rapidly.

The provision in the 2013 Act to permit pre-retirement withdrawal up to 25 percent of the accumulated balances (subject to conditions) reflects a trade-off between the need for liquidity during working years and retirement accumulation. Conditional withdrawals such as for housing or health care have the potential to increase transaction costs (including hassle costs), and provide incentives for rent seeking behavior.

The PFRDA could therefore consider the following type of arrangement.

The contribution rate for the mandatory pension account is 20 percent. Three fourths of the monthly contribution could be channeled into one sub-account, the balances from which cannot be withdrawn until the stipulated retirement age. The remaining can be channeled into another sub-account from which a member may withdraw after a suitable membership period, and at infrequent intervals, without giving any reasons. This will minimise transaction costs and the opportunities for rent seeking. The pre-retirement withdrawal provision will however complicate investment strategies of the asset managers.

The 2013 Act also provides a guaranteed return option, but wisely leaves the details to PFRDA. This will now be one of the options for the members.

Third, the 2013 Act leaves the payout phase arrangements, especially mandatory annuatisation of some of the balances unchanged. It may be useful to reconsider this provision as globally it has been difficult to organise annuity markets as matching of long term assets and liabilities has proved to be difficult. Flexibility in the timing of the annuity purchase and additional options such as group annuities and phased withdrawal products not part of the insurance pool, merit consideration.

Fourth, the 2013 Act clarifies the scope of PFRDA’s regulatory purview by explicitly stating that any pension scheme not regulated by any other enactment will be covered. This provision, along with removal of the 15-year superannuation in public enterprises will enable these employees to benefit from the NPS architecture and PFRDA’s supervision.

While not included in the Act, closing of the current Public Provident Fund (PPF) to future subscribers and directing them to NPS has the potential to bring about greater policy coherence and better governance and regulation. The PPF interest rate is administered, and the investment policies and performance of the PPF balances is non-transparent. The PPF also weakens the fiscal discipline, and prevents contestability between public sector and private sector banks.

The passage of the Act will also provide welcome impetus to PFRDA’s NPS-Corporate initiative to encourage private corporate superannuation plans to utilise the NPS architecture.

The policymakers however may consider permitting greater choice to the members, while increasing contestability, by permitting members of these provident funds (such as The Coal Mines Provident Fund) to choose between their existing provident fund and the NPS.

The above will increase contestability and better policy coherence among different mandatory pension schemes.

The Finance Minister’s suggestion that the Employees’ pension Scheme (EPS) of the Employees Provident Fund Organization (EPFO) be merged with the NPS for future members also has the potential to bring about greater policy coherence, and professionalism.

Fifth, the mandatory pension schemes, and superannuation schemes of the public and private sector corporations cover only around one-sixth of the labor force. This suggests that PFRDA’s efforts to attract voluntary members from different income groups would be crucial.

For middle and high-income groups, parity in tax-treatment with other pension products and providers would help. Currently, unlike some schemes such as those by the EPFO, the NPS attracts income tax at the payout stage. Perhaps the new DTC (Direct Taxes Code) will address this issue.

The Swavalamban scheme, with co-contributions by government for low-income individuals, is potentially an important instrument for increasing voluntary membership of the NPS. In August 2013, Swavalamban had 2 million members (about two-fifths of the total) but a total balance of only INR. 6.5 billion, less than two percent of total balances in NPS. The main challenges are finding innovative ways to reduce transaction costs, improving the retention rate of members, and enhancing the density of contributions over a lifetime.

Finally, a modern pension system in India requires a social pension which is fiscally sustainable and whose delivery system effectively reaches those who are the intended beneficiaries. The current Old Age Pension Scheme (OAPS), whose responsibilities are shared between the Union government and individual states, needs to be made fiscally sustainable and improve the delivery system. In its design, recent entitlement programs, such as the provision of food grains at subsidised rates, need to be incorporated to decide eligibility and level of benefits.

The above analysis strongly suggests that while the PFRDA Act 2013 is helpful, constructing and sustaining a modern pension system for rapidly ageing India will require sustained efforts by all the stakeholders in many areas.

Photo: rileyroxx


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